update.zip s are packages containing replacements for parts of an android system. The packages contain all the files it the update is intended to replace, and a script that will do the replacement when its run.
Update.zips can come from OTA updates but in some cases it is necessary to manually download and put an update.zip in some special folder. However, the update.zip is still detected and applied in the same manner.
What part of android detects and handles update.zips?